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CASE 12/95

Members:
BH Burns DP
BC Lock M
DJ Trowse M

Tribunal:
Administrative Appeals Tribunal

Decision date: 16 March 1995

BH Burns (Deputy President), BC Lock (Member), DJ Trowse (Member)

This reference concerns the deductibility, for income tax purposes, of interest paid on borrowed monies together with associated borrowing expenses. These matters are to be resolved in accordance with the provisions of sub-sections 51(1) and 67(1) of the Income Tax Assessment Act 1936 (``the Act''). The parties agree that the applicant and his spouse were in receipt of income jointly and on that basis the association giving rise to that income comes within the definition of ``partnership'' as it appears in sub- section 6(1) of the Act. It follows that the provisions of Division 5 of Part III of the Act are applicable and that the expenditure in question, if deductible, shall be brought to account in the determination of either, and here reference is made to the definitions appearing in section 90 of the Act, ``net income'' or ``partnership loss''. The applicant's share of those calculations need to be included in his personal returns and it is the extent of those amounts which is in dispute.

2. The Tribunal had before it the documents lodged by the respondent pursuant to section 37 of the Administrative Appeals Tribunal Act 1975 as modified by section 14ZG of the Taxation Administration Act 1953, together with other materials lodged at the hearing. Evidence was given by the applicant, who was represented by Mr K.D. Schurgott of counsel. The respondent was represented by Ms A.J. Macdonald of counsel.

3. The Tribunal makes the following findings of fact which are not in dispute. Prior to December 1989, the applicant was employed by a semi-government institution in New South Wales as a research manager. In March 1988 the applicant was seconded to S Ltd which is located in Adelaide. Whereas the applicant moved to Adelaide at that time, his family did not follow until June 1988. The applicant resigned from his position with the institution in December 1989 so that he could take up a permanent position in Adelaide with S Ltd.

4. During his time in New South Wales, the applicant and his family resided in a house positioned in an outer suburb of Sydney and which had been built on land purchased jointly by himself and his spouse in 1966. It seems that the total cost of land and improvements was in

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the vicinity of $40,000 and that, at all relevant times for the purpose of this dispute, the property remained unencumbered. Notwithstanding the move to Adelaide, it was resolved that the property, then estimated to have a value of approximately $400,000, be retained and leased without delay and accordingly it was rented as from 27 June 1988.

5. It is the income flowing from the rental property that, in the opinion of the applicant should, for the purposes of calculating the net income of the partnership, be reduced by the expenditure in question and which, as will be seen later in these reasons was incurred at a subsequent point in time. The Tribunal finds the amounts of rental received during the 1990 and 1991 years were $23,317 and $24,447 respectively.

6. The Tribunal makes the following findings. On 5 January 1990 the applicant and his spouse purchased a residential property in Adelaide for a consideration of $172,000. The acquisition was funded partly ex their own resources and the balance, $146,000, by way of a loan from the NSW State Bank which was transacted by the Bank making that sum directly available to the solicitors responsible for settlement. The loan, which was secured by way of a registered mortgage over the Adelaide property, was for a period of five years and required that interest only be payable at a fixed rate of 15.5% per annum. The following outgoings pertaining to this borrowing were incurred by the applicant and his spouse during the years under review- 

              1990  Interest              $22,630
                    Borrowing Expenses     $1,543

              1991  Interest              $24,037

The question for determination is whether the above are allowable deductions in terms of sub- sections 51(1) and 67(1) of the Act. If they do so qualify, the outgoings will be brought to account in calculating the partnership net income which is then shared between the applicant and his spouse. There is no dispute that the applicant and his family have resided in the Adelaide property since its purchase.

7. There was some conflict as to the reasons for the retention of the property in New South Wales. It seems that the applicant was keen to promote the notion of investment, whereas the respondent, having particular regard to statements made by the applicant in his objection, contended that the possibility of a return to that place was of prime importance. Having considered all of the evidence on this issue the Tribunal finds that the predominant, if not sole, reason for the continued holding of the property was as a safeguard against the possible relocation to the former address.

8. The following are the relevant provisions of the Act:

``6(1) ... `partnership' means an association of persons carrying on business as partners or in receipt of income jointly, but does not include a company;

90 In this Division-

...

`net income', in relation to a partnership, means the assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions except...;

`partnership loss', in relation to a partnership, means the excess (if any) of the allowable deductions, other than deductions allowable under section 79E, 80, 80AA or 82AAT, over the assessable income of the partnership calculated as if the partnership were a taxpayer who was a resident.

91 A partnership shall furnish a return of the income of the partnership, but shall not be liable to pay tax thereon.

92(1) The assessable income of a partner in a partnership shall include-

  • (a) so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was a resident; and
  • (b)...

92(2) Where a partnership loss is incurred by a partnership in a year of income, there shall be allowable as a deduction to a partner in the partnership-

  • (a) so much of the individual interest of the partner in the partnership loss as is attributable to a period when the partner was a resident; and
  • (b)...

51(1) All losses and outgoings to the extent to which they are incurred in gaining or

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producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature,...

67(1) Subject to his section, so much of the expenditure incurred by the taxpayer in borrowing money used by him for the purpose of producing assessable income as bears to the whole of that expenditure the same proportion as the part of the period for which the money was borrowed that is in the year of income bears to the whole of that period shall be an allowable deduction.''

9. The language of sub-section 51(1) has been the subject of careful analysis on many occasions and yet it is important to observe that whatever has been or will be postulated as to its interpretation represents a gloss on the words contained in the legislation. Subject to that reservation, certain indicators have evolved-

  • • for expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income, it must be incidental and relevant to that end; the words ``incurred in gaining or producing the assessable income'' mean in the course of gaining or producing such income - see
    Ronpibon Tin N.L. v F.C. of T.; Tongkah Compound N.L. v. F.C. of T. (1949) 8 ATD 431 at p. 435; (1949) 78 CLR 47 at p. 56
  • • it is both sufficient and necessary that the occasion of the outgoing should be found either in whatever is productive of assessable income or, if none be produced, in whatever would be expected to produce assessable income - see Ronpibon Tin N.L. (supra) at ATD p. 436; CLR p. 57
  • • the expenditure must have the necessary connection with the operation or activities which more directly gain or produce assessable income so as to meet the statutory requirement that the expenditure be incurred ``in gaining or producing the assessable income'' -
    Charles Moore & Co (W.A.) Pty Ltd v F.C. of T. (1956) 11 ATD 147 at p. 148; (1956) 95 CLR 344 at p. 350
  • • in a determination as to whether or not an outgoing is incurred in or in the course of gaining or producing assessable income due regard must be given to matters concerned with the essential character of the outgoing -
    Kenneth Edmund Lunney v F.C. of T. and Nigel Ralfe Hayley v F.C. of T. (1958) 11 ATD 404 at p. 413; (1957-1958) 100 CLR 478 at p. 499

10. The primary test in deciding the deductibility of interest paid on borrowed funds depends upon the use to which the money is put. An examination of the cases relevant to this issue makes it quite clear that interest will qualify for deduction where the monies so borrowed are used to acquire income producing assets or to meet expenditure incurred in the conduct of a business operation. The emphasis on use is demonstrated in the following passage taken from the decision of Brennan J in the case of
URE v F.C. of T. 81 ATC 4100 (at 4104)-

``An outgoing of interest may be incidental and relevant to the gaining of assessable income where the borrowed money is laid out for the purpose of gaining that income (
F.C. of T. v. Munro (1926) 38 C.L.R. 153 at pp. 170, 171, 197;
Texas Co. (Australasia) Ltd. v. F.C. of T. (1940) 63 C.L.R. 382 at p. 468). The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use.''

11. There may be instances where there is no obvious commercial explanation for the borrowing and in those cases one should, in the process of characterisation, have regard to ``the whole set of circumstances including direct and indirect objects and advantages which the taxpayer sought in making the outgoing'' - see joint decision of Deane and Sheppard JJ in URE v F.C. of T. (supra). Some objects may indicate a commercial use whereas others may point more in the direction of a private or domestic purpose. Where such a mixture occurs apportionment will be necessary.

12. A further test, which shall be referred to as the substitution of partners capital, has its genesis in the decision of the Full Federal Court in the case of
F.C. of T. v J.D. Roberts; F.C. of T. v Smith 92 ATC 4380. There the matter in contention was the deductibility of interest paid by a partnership of practising solicitors on monies borrowed from a bank to enable the repayment to partners of portion of their capital and which in the books of the partnership had been debited to accounts described as capital accounts. Notwithstanding the private use by

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the partners of the funds withdrawn, it was held - based upon findings that the funds withdrawn had been employed in the conduct of the partnership business and that the bank borrowing replaced those funds - that the interest incurred on that borrowing met the statutory description of interest incurred by the partnership in the gaining or production of its assessable income.

13. The Tribunal accepts that the tests outlined are of assistance in the resolution of this current dispute and yet the caution adverted to by Hill J in
Kidston Goldmines Ltd. v. F.C. of T. 91 ATC 4538 and repeated in Roberts and Smith (supra) is heeded. As Hill J pointed out, they are but tools to assist in the resolution of what is essentially a question of fact and in no way should they be seen as a substitute for the language contained in sub-section 51(1). His comments in Roberts and Smith (supra) at 4388 on this issue together with the deductibility of interest incurred on funds borrowed as a substitution of partners capital are to the point-

``The issue continues to be whether the interest outgoing was incurred in the income producing activity or, in a case falling to be tested under the second limb, in the business activity which is directed towards the gaining or producing of assessable income. As the cases, including Kidston, all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary or appropriate: cf
F.C. of T. v. Total Holdings (Australia) Pty. Limited 79 ATC 4279 and the discussion of tracing in the context of s. 51(1) in Parsons, Income Taxation in Australia, Law Book Co, 1985 at 348ff.

For example, let it be assumed that there are undrawn partnership distributions available at any time to be called upon by the partners. The partnership borrows from a bank at interest to fund the repayment to one of the partners who has called up the amount owing to him. That partner uses the moneys so received to purchase a house. A tracing approach, if carried beyond the payment to the partner, encourages the argument raised by the Commissioner in the present case that the funds were used for the private purpose of the partner who received them. But that fact will not preclude the deductibility of the outgoing. The funds to be withdrawn in such a case were employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income.''

14. The submissions made on behalf of the applicant are summarised hereunder-

  • • that the receipt of joint income, that is the rental from the New South Wales property, brings the leasing arrangement within the extended definition of partnership as it appears in the Act
  • • that the New South Wales property is an asset of that partnership
  • • that the value of the property in June 1988, that is upon the deemed creation of the partnership, was in the region of $400,000 which in turn represented the capital invested in the partnership by the applicant and his spouse
  • • that the advance of $146,000 from the bank in January 1990 was in fact a borrowing made by the partnership
  • • that the $146,000 was applied by the partnership in a reduction of the capital accounts of the applicant and his spouse and on that basis the loan should be seen as a substitution of partners capital, and
  • • that on the authority of Roberts and Smith (supra) and
    Yeung & Anor v F.C. of T. 88 ATC 4193 it can be said that the interest and borrowing expenses pertaining to the loan were incurred in an income producing activity

15. In denying the deductions sought, the respondent relies upon the following contentions-

  • • that the leasing arrangement does not constitute a partnership at general law
  • • that the deeming provision contained within the definition of partnership is restricted in its application to the provisions of the Act and more specifically to those forming part of Division 5 of Part III, and that to regard an arrangement coming within the deeming as comprising assets and capital is an unintended and incorrect extension

    ATC 180

  • • that the principle espoused in Roberts and Smith (supra) is limited to partnership at general law only and thus it has no application to the matter under review
  • • that the decision in Yeung (supra) is incorrectly founded and should not be followed
  • • that, as an alternative and conceding the existence of a partnership of wider ambit, the monies borrowed were advanced by the bank to the applicant and his spouse as individuals for a private purpose and not to a partnership to enable the partners to withdraw portion of their capital.

16. For the sake of completeness the Tribunal will address all of the submissions forthcoming from both parties and yet in its view the primary and fundamental question is whether the partnership - and here the niceties of deemed partnerships as opposed to partnerships at general law are put to one side - was involved in the borrowing of $146,000. The Tribunal heard evidence that the rent producing property was retained as an investment, that the mode of the borrowing adopted as distinct from the more usual long term home loan supported the concept of investment, and that the initial intention was to use the New South Wales property as security for the advance of the $146,000. It seems that when those factors are considered collectively, one should be able to conclude that it was the partnership that was the borrower. The Tribunal found the evidence on the issue of investment unimpressive and, as previously opined in these reasons, the retention was based upon a possible return to New South Wales. The method of borrowing is in our opinion of little moment. It seems possible that the short term of five years was grounded on the premise of the property in New South Wales being sold after the expiration of an introductory trial period in South Australia. On the point of intention, the Tribunal takes the view that in the circumstances of this reference attention and emphasis should be directed more to what in fact happened rather than what may have been in mind at some earlier stage. On the applicant's own admission he is not conversant with the laws pertaining to income tax and thus it seems unlikely that he was aware of the extended meaning bestowed on partnerships. With that in mind the Tribunal has difficulty with the image of the applicant wearing his partners hat at the time of organising the loan.

17. The Tribunal finds that the monies were borrowed by the applicant and his spouse as individuals and not by any other entity either deemed or otherwise. The funds were used to purchase a residence for the applicant and his family and thus the essential character of the outgoings flowing from the loan is of a private and domestic nature. The loan played no role whatsoever in the gaining of the rental income and thus the conclusion that the interest and borrowing expenses were not incurred in producing the assessable income.

18. In the event that the Tribunal has erred in reaching the above conclusion, it becomes necessary to address the other matters submitted in the course of the hearing. As a preliminary it is noted that the applicant accepts that he and his spouse were not carrying on a business in common with a view of profit, that is that the rent producing activity does not come within the description of being a partnership at general law. Furthermore, it is accepted by the respondent that the receipt of joint income brings that occurrence within the income tax definition of partnership. The question that remains is the extent of the relationship resulting from the deeming provision contained with the definition.

19. The deeming provision of s. 109 of the Act was considered by the Full Federal Court in
F.C of T. v Comber 86 ATC 4171; (1986) 64 ALR 451. One of the questions being examined was whether dividends deemed in terms of s. 109 of the Act constituted assessable income under s. 44(1)(d) of the Act, and comments made by Fisher J at ATC 4177; ALR 458 on the construction of deeming provisions are pertinent to this issue-

``... The Commissioner's consequential contention is that as a deemed dividend it is assessable income primarily under para. 44(1)(d) of the Act. I reject this submission. I am of opinion that deeming the excess to be a dividend will not make that amount assessable income nor will it make it even potentially assessable income in the hands of anyone other than a shareholder.

If the contention of the Commissioner were correct, it would mean that by the use of the statutory fiction the section would go beyond the express deeming of the excess to be a dividend. It would in addition imply deeming the person in receipt of the excess to be receiving it as a shareholder and also

ATC 181

that the deemed dividend was paid out of the profits of the company. Paragraph 44(1)(a) would not be applicable unless such additional deemings are implied.

I find the Commissioner's construction unacceptable. In my opinion deeming provisions are required by their nature to be construed strictly and only for the purpose for which they are resorted to (
Ex parte Walton (1881) 17 Ch. D. 746 per James L.J. at 756. It is improper in my view to extend by implication the express application of such a statutory fiction.''

(Tribunal emphasis)

20. Another case in point is
F.C. of T. v McDonald 87 ATC 4541. In question was the arrangement between Mr and Mrs McDonald to share profits from jointly held property on an unequal basis and which required a determination as to whether the McDonald's were merely notional ``partners'' for purposes of the Act (i.e. merely co-owners) or were ``true'' partners under the general law. On that subject Beaumont J had the following to say at 4550-

``In my opinion, no partnership under the general law subsisted between the respondent and his wife. Their relationship was one of co-ownership, and even if they were deemed to be partners by reason of sec. 6(1) of the Act, this circumstance is immaterial for our purposes. As has been noted, their notional `partnership' will carry with it the consequence that they are to be treated as a `partnership' for some purposes. It does not follow that the respondent can deduct the whole of the losses.''

(Tribunal emphasis)

21. The Tribunal is of the view that the purpose of the definition of ``partnership'' as it appears in section 6(1) of the Act is the application to arrangements answering that description of Division 5 of Part III of the Act and, in the circumstances of this reference, particularly sections 90, 91 and 92. Against that background, and here the words of Fisher J are repeated, the deeming provisions are required by their nature to be construed strictly and only for the purpose for which they are resorted to and it is improper to extend by implication the express application of such a statutory fiction. This fiction does not, in our opinion, cloak an arrangement of the kind now being contemplated with the additional refinements of partnership assets and liabilities and partners capital accounts. On that basis the Tribunal finds that there are no partnership assets or liabilities nor are there capital accounts capable of being accessed by the applicant or his spouse. What remains is a relationship of co- ownership as joint tenants which is more accurately described as an investment rather than as partners in a business operation. For these reasons the Tribunal concludes that the argument of the bank loan being used to replace portion of the capital accounts of the partners is not available to the applicant. While this conclusion is in accord with the submission pressed upon us by the respondent, it is observed in passing that such a result appears to be in direct conflict with some of the opinions expressed in Draft Taxation Ruling TR 93/D38.

22. The decisions in Roberts and Smith (supra) have been considered in detail and in the Tribunal's opinion the existence of a partnership at general law was fundamental to the outcome. It was only that arrangement which gave rise to the formality of partners capital accounts and the substitution thereof of funds borrowed from the bank. Bearing in mind the Tribunal's earlier comments on the limiting parameters of deemed partnerships, the Tribunal takes the view that the substitution of funds test emanating from Roberts and Smith (supra) is of no assistance to the applicant.

23. Not surprisingly the applicant placed substantial reliance upon the decision reached by Davies J in
Yeung & Anor v F.C. of T. 88 ATC 4193. In that case Dr Yeung and members of his family purchased several rent producing properties in their joint names. A statutory partnership existed between them in the sense that they were in receipt of joint income. Subsequent to those acquisitions the ``partnership'' borrowed loan monies from a related company which were then used to repay portion of the funds originally advanced by Dr Yeung and his wife. In holding that the interest incurred was an allowable deduction Davies J had the following to say at 4204-

``I am prepared to accept that from the partnership's point of view, what occurred was that two of the partners decided to withdraw funds from the partnership. It does not materially matter whether those funds were loan funds or capital which the partners had invested in the properties. The notional payment out to Dr and Mrs Yeung

ATC 182

and the borrowing of an amount from Ozanu Pty. Ltd. necessarily effected a change in the capital interests which each of the partners had in the partnership. What the partnership achieved by the borrowing from Ozanu Pty. Ltd. was the maintenance of the income earning properties. Funds were withdrawn, but were replaced by loan funds and the income-earning properties remained held by the six members of the family.''

24. The major distinguishing feature between the facts of Yeung (supra) and the current issue is the acceptance by Davies J that the monies were borrowed by the partnership and our rejection of such a result. On that basis alone, the Yeung decision has no application to the facts of this reference. However, in view of the force of the submissions made regarding Yeung the Tribunal feels obliged to make the following additional observations. First, in reaching his decision, Davies J did not express an opinion on whether there existed a partnership at general law; instead he accepted that the receipt of joint income was sufficient (see p. 4200). Having regard to the number of properties involved, the extent of the monies invested and the perception of the arrangement by Dr & Mrs Yeung, it seems at least possible that a partnership at general law may have existed. Whether such a possibility played any role in the decision making process is not known and yet it would explain what some would see as the broad approach applied by Davies J. Secondly, and here it is assumed that the above possibility was not recognised, Davies J appears to be in conflict with the more narrow course plotted by Beaumont J in McDonald (supra) and Fisher J in Comber (supra). Finally, the Tribunal considers that the following comments made by Hill J in Roberts and Smith (supra) at 4389 cast considerable doubt as to the application of the substitution of partners capital principle to partnerships other than those that are partnerships at general law-

``For present purposes it is sufficient to note that the result reached in Yeung seems clearly correct if the case is viewed simply as one involving a borrowing to fund the repayment of moneys originally advanced by a partner and used as partnership capital particularly given that the original funds were used to purchase the rental property.''

In our understanding of this passage, it seems that the words chosen are more appropriately allied to partnerships at general law rather than those resulting from no more than the co- ownership of an income yielding property. Indeed our perception of what was said could be interpreted as a warning against the wider use of the substitution of partners capital test to arrangements which rely entirely upon the statutory fiction stemming from the extended meaning contained in sub-section 6(1). If a decision on this matter had been necessary, the Tribunal would have heeded what we see as the warning issued by Hill J and preferred the more restrictive approach suggested by Beaumont J and Fisher J.

25. Before concluding it is appropriate that the Tribunal refers to the respondent's submission, albeit faintly put, which is based on the alternative assumption that a partnership of the wider kind subsisted and that that entity was responsible for the borrowing of $146,000. Allowing for such an outline, the respondent maintains that the amount borrowed far exceeds the capital of the partners which he argues would be in the vicinity of $40,000, that is the cost of the property being transferred into the partnership, and not the market value of $400,000 which was said to prevail at the point of introduction. In that event the contention that the $146,000, once obtained by the partnership, was utilised to repay partnership capital is no longer available and thus once again the exclusion of the substitution principle. It is clear that this proposition has its origin in Roberts and Smith (supra) and more specifically that part of Hill J's decision which discusses in some detail what constitutes partnership capital. In that regard reference was made to Lord Lindley's definition which, inter alia, states that ``by the capital of a partnership is meant the aggregate of the sums contributed by its members for the purpose of commencing or carrying on the partnership business, and intended to be risked by them in that business''. Hill J went on to conclude that any increases resulting from the revaluation of partnership goodwill could not be said to represent funds invested as capital in the partnership. There the asset being revalued had reposed in the partnership since its formation. Here the issue is the value of an asset being introduced into the partnership by the partners. The Tribunal considers that capital contributions are not necessarily restricted to advances by way of cash and that the transfer of assets in specie

ATC 183

may be regarded as contributions for the purpose of commencing or carrying on of a partnership and that the value of a contribution answering this description is the amount being risked by the member of a partnership. Where an asset is being introduced as a capital contribution, a suggestion that the adoption of a value other than market value is unrealistic and commercially flawed. In this unlikely scenario the Tribunal rejects the respondent's submission that the availability of capital be reduced to a figure equivalent to original cost.

26. In all the circumstances the Tribunal finds that the claimed expenditure was not incurred in the production of assessable income and for that reason no deduction is permitted under either s. 51(1) or s. 67(1). Additionally, the Tribunal is of the view that, having regard to the use of the borrowed monies, the interest incurred was of a private or domestic nature. It follows that those items of expenditure should not be brought to account in any determination of the applicant's share of either ``net income'' or ``partnership loss''.

27. For the reasons enunciated above, the Tribunal affirms the respondent's decision on the objection.


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